Magazine

The New Financial Heavyweights

November 11, 2007

By Jack Ewing Even in the financial world, Gao Xiqing isn't a household name. Yet the 54-year-old civil servant in Beijing oversees a pile of cash that would make any hedge fund manager swoon. Gao is general manager of the $200 billion China Investment Corp., created this year to invest the mainland's foreign currency reserves in global capital markets. Don't mistake him for some faceless Chinese bureaucrat, though. He graduated from Duke University School of Law in 1986, spent two years with a big New York law firm, and then went home to help craft China's securities regulations.

Here's a combination the global financial Establishment better get used to: a seemingly limitless pool of capital overseen by Western-trained managers. U.S. officials have been fretting about China Investment and other so-called sovereign wealth funds, calling on such outfits to provide greater insight into their operations. But there's little the West can do. Russia, the Persian Gulf states, China, and others have amassed fortunes from exports of gas, oil, or manufactured goods, and now they're looking to supercharge the returns they're getting from that money. All told, these funds today control more cash than the world's hedge funds combined: $2.8 trillion vs. $1.7 trillion, according to Morgan Stanley (MS). By 2011 that figure may hit $8 trillion or more.

For Americans and Europeans, the big worry is what sovereign fund managers plan to do with their huge pots of cash. Because their interests don't always match those of the West, the looming question is whether they'll simply go for maximum profit, or also pursue more ominous political goals. The increasing economic clout of undemocratic governments could mean that "our markets will be less transparent, less yielding to outside law enforcement," Christopher Cox, chairman of the Securities & Exchange Commission, said in a speech at Harvard University on Oct. 24.

While few funds so far have thrown their weight around for political and strategic ends, state-controlled companies from the same countries have done so, and many fear the funds will follow in their footsteps. Russia's state-owned energy giant Gazprom, for instance, cut off gas supplies to Ukraine last year after relations between the two countries cooled. In October, Industrial & Commercial Bank of China paid $5.6 billion for 20% of South Africa's largest bank, and last year state-owned oil company CNOOC bought into a Nigerian oil field for $2.3 billion. Dubai funds, meanwhile, have sought to bolster their hometown's reputation as a world financial capital by taking stakes in Nasdaq and the London Stock Exchange.

If Western officials are worried about the funds, they have only themselves to blame. The insatiable appetite of Americans and Europeans for oil and cheap manufactured goods has flooded developing countries with foreign currency. Western policymakers have spent years pushing to open global capital markets, creating the conditions that allow sovereign wealth funds to thrive. And as U.S. credit markets limp through the subprime mortgage crisis, the sovereigns may be the best place to go for financing. "The U.S. is going to have to import large amounts of capital from the rest of the world as long as there's a big imbalance between what we save and what we spend," says Robert D. Hormats, vice-chairman of Goldman Sachs (International) (GS).

Saudi Arabia, China, and other countries have traditionally plowed their reserves into U.S. government bonds earning perhaps 5% annually, but they're no longer satisfied with such paltry returns. During the past year, investment operations controlled by the emirate of Dubai have bought New York high-end clothing retailer Barney's and German industrial-packaging maker Mauser, and have taken 3% stakes in both Airbus parent EADS and ICICI, India's No. 2 bank. Singapore's Government Investment Corp. owns some $80 billion worth of real estate assets worldwide, including such trophies as the 60-story AT&T (T) Corporate Center in Chicago, Shiodome City Center in Tokyo, and Merrill Lynch's (MER) European headquarters in London. And Gao's China Investment Corp. in May agreed to pay $3 billion for a 9.9% stake in private equity firm Blackstone Group (BX) (although the shares have lost 18% of their value).

The funds are already becoming the go-to guys for financial heavyweights the world over. In July, for instance, London's Barclays (BCS) bank needed billions in fast cash to bolster its bid for Dutch rival ABN Amro (ABN), but the subprime crisis was raging and the usual sources of credit were in lockdown mode. Barclays President Bob Diamond hopped an overnight flight to Singapore for an audience at the art deco headquarters of another of the city-state's sovereign funds, Temasek Holdings. Within hours, Temasek pledged $5 billion. The Barclays bid ultimately failed, but the transaction left Temasek with a 2% stake in the bank. And in September, Temasek scored an mergers and acquisitions victory when the fund teamed up with its subsidiary Singapore Airlines to take a 24% stake in China Eastern Airlines, acing out Hong Kong's Cathay Pacific.

Temasek has a track record that any of the newcomers might envy. Founded in 1974 to invest Singapore's budget surpluses, Temasek has averaged a return of 18% annually and now holds assets worth $110 billion. Its diverse portfolio includes 25% of Indian broadcaster INX Media, 8% of Austrian vaccine-maker Intercell, and a slew of Asian banks including 5% of Bank of China. Temasek is run by the wife of Prime Minister Lee Hsien Loong, Ho Ching, who holds a master's degree from Stanford University. And the fund includes foreign talent, such as second-in-command Simon Israel, a New Zealander who previously headed the Asian operations of French food giant Danone.

Investment banks and asset managers love the sovereigns. While such funds are still only about an eighth the total size of the world's pension funds (which have $21.6 trillion in assets), they're becoming increasingly important customers for investment banks. Bankers from the world over have set up shop in Dubai, aiming to serve the Gulf region's sovereign funds and other deep-pocketed investors. Norway uses more than 50 outside firms to help manage its $367 billion fund, handing out $73 million in performance bonuses last year to the likes of Lehman Brothers and Morgan Stanley. All told, the sovereigns are likely to fork over fees of $4 billion to $8 billion to asset managers worldwide over the next five years, Merrill Lynch estimates. "The big investment banks are salivating at the prospect of [doing business with] these funds," says Kenneth S. Rogoff, a professor at Harvard and former chief economist at the International Monetary Fund.

Many economists argue that the sovereigns make global capital markets safer. The funds don't have to worry about panicky investors withdrawing money when markets tank, and most don't have to make regular payments the way pension funds do. That means they can take the long view, helping stabilize the prices of stocks and bonds they own. "We are able to hold on to our positions in times of turmoil," says Martin Skancke, director general of the Asset Management Dept. in the Norwegian Finance Ministry, which oversees the country's Government Pension Fund. (Despite its name, the agency doesn't actually pay pensions and is instead designed to build a national nest egg for the day when Norway's oil reserves run dry.) Sovereign wealth funds may also take a more gentle approach to acquisitions than private equity or hedge fund investors, whose aggressive restructuring often provokes public ire. When Dubai International Capital bought British theme park operator Madame Tussauds in 2005, for instance, it left management in place. "We don't have the resources to manage companies or spend months finding replacement management teams," says Sameer Al Ansari, CEO of Dubai International.

Western policymakers fret that, as with hedge funds, no one knows for sure what most sovereign funds are up to. Without reliable information about their investment strategies and holdings, rumormongering takes over, which can create turmoil in the markets. While Norway issues a detailed annual report, the Abu Dhabi Investment Authority, with holdings estimated at as much as $875 billion, discloses almost no information. Its Web site consists of a single page, offering only an address and a phone number. Analysts assume most of the Abu Dhabi money is in ultrasafe U.S. Treasury bills, but a recent Citigroup report said the fund also has extensive investments in Middle East banks as well as two cement companies in the region. Through its Mubadala Fund, with a value estimated at $10 billion, the government of the United Arab Emirates is also experimenting with riskier investments. In September it paid $1.35 billion for a 7.5% stake in private equity firm Carlyle Group.

To counter concerns over the funds' lack of transparency, U.S. and European officials are pressing the sovereigns to disclose more about their activities. Leaders of the Group of Seven nations, meeting in Washington in October, asked the International Monetary Fund to examine the issue—although it's unclear what the IMF might be able to do. The goal is to head off potentially harsher measures by American or European policymakers that might hurt the U.S. economy and its commercial interests abroad. "We are worried about an over-reaction leading to protectionism, putting up barriers in the U.S. to legitimate investment," says Clay Lowery, Assistant Secretary for International Affairs at the Treasury Dept. In any event, it may be hard for Western policymakers to argue that the sovereigns should be more open without imposing similar rules on hedge funds or private equity, which are generally no more transparent. The best hope is that sovereign funds decide it's in their interest to open up.

One of the biggest victims of the rising power of the sovereigns could well be the dollar. As the funds shift their enormous assets away from U.S. Treasury bills, for instance, one of the greenback's biggest pillars of support could start to crumble. And with the funds showing a strong preference for emerging markets, the dollar could suffer even more. "Why would you want assets denominated in a declining currency?" asks Merrill Lynch economist Alex Patelis.

So far, the sovereign funds' track record suggests they will move carefully to avoid provoking major opposition. When Dubai was ready to seal its deal with Nasdaq, for instance, it spent big money on Washington lobbyists and carefully briefed key legislators. "It's not our country," says Soud Ba'alawy, executive chairman of Dubai Group, an investment fund controlled by the emirate's ruler. "Whether we like it or not, we have to adapt."

With Chi-Chu Tschang in Beijing, Assif Shameen in Singapore, Stanley Reed in London, Jane Sasseen and Emily Thornton in New York, and Jason Bush in Moscow